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Bank of Italy Knew for Years Paschi Masked Losses, Report Shows

(Bloomberg) -- Italy’s central bank knew Banca Monte dei Paschi di Siena SpA papered over a loss of almost half a billion dollars two years before prosecutors were alerted to the complex transactions, documents revealed in a Milan court show.

A 2010 report from the Bank of Italy, headed at the time by Mario Draghi, now president of the European Central Bank, shows inspectors were aware that a 2008 trade struck with Deutsche Bank AG was the mirror image of an earlier deal Monte Paschi had with the German lender. The Italian bank was losing about 370 million euros ($431 million) on the earlier transaction, dubbed Santorini, as of December 2008. The new trade posted a gain of roughly the same amount and allowed losses to be spread out over a longer period, the document shows.

The newly revealed report -- dated Sept. 17, 2010, and marked “private” -- shows the Bank of Italy was aware that by choosing not to book the trade at fair value Monte Paschi avoided showing a loss at the time. If the bank had used a mark-to-market valuation in the fourth quarter of 2008, it would have been included in its year-end report as the credit crisis was cresting, with potentially grave consequences on the bank’s finances.

Market Manipulation

Deutsche Bank and former executives of the Frankfurt-based lender are on trial in Milan for colluding with Monte Paschi on charges of market manipulation and false accounting. At a hearing Oct. 3, a lawyer for the former employees, Giuseppe Iannaccone, introduced the central bank’s 2010 findings as part of their defense.

The lawyer also elicited testimony at the hearing from Italian central bank inspectors on how the transactions made it look as if the losses had disappeared. Iannaccone asked a central bank official whether the Bank of Italy knew the loss was offset.

“That’s correct,” Mauro Parascandolo, the official, responded. Asked if the Bank of Italy sought to probe or file a complaint against Monte Paschi after its inspections, he answered, “No.”

A spokeswoman for the Bank of Italy said by email that a suggestion about what the central bank knew in 2010 “is the position taken by the defendants in the case.” She said she couldn’t comment further because the trial is still going on. Iannaccone and spokesmen for Monte Paschi and Deutsche Bank declined to comment.

Postponing Pain

The 2008 trade, which neither Monte Paschi nor regulators disclosed to the public, first came to light when Bloomberg News reported on the transactions in January 2013. The gambit only postponed the financial pain, prompting the bank to bleed cash as losses mounted. Two government bailouts to shore up the bank’s finances, in 2009 and 2013, were insufficient as bad loans also eroded capital, leading the government to nationalize the lender this year.

Since 2008, Italian taxpayers and private investors have injected more than 8 billion euros to prop up Monte Paschi, the world’s oldest bank.

The Bank of Italy has said its 2010 inspections didn’t reveal anything about Santorini that required alerting prosecutors or imposing penalties, according to a chronology of the episode the central bank published in January 2013. Instead, it focused its supervisory activities on the effect the trade had on Monte Paschi’s liquidity. The regulator demanded daily health reports from the bank.

The central bank said in its 2010 report that it didn’t have “powers as regards accounting” and that the matter needed further study. A spokesman for the ECB declined to comment about the Bank of Italy report.

Squirreled Away

The Bank of Italy conducted another inspection of Monte Paschi in September 2011, and in November of that year, two weeks after Draghi became president of the ECB, the Italian central bank’s new leadership summoned Monte Paschi’s management to Rome.

The bank’s top executives resigned, and less than a year later, on Oct. 15, 2012, Monte Paschi told the Bank of Italy it had found previously undisclosed paperwork squirreled away in a safe at its Palazzo Salimbeni headquarters in Siena. That document, a framework agreement, was key to understanding a similar derivatives deal involving Tokyo-based Nomura Holdings Inc., as well as the Deutsche Bank trade, the central bank said in 2013.

The discovery of the framework agreement sparked the Bank of Italy to alert prosecutors about the transactions, according to the central bank’s chronology.

The trial is expected to last at least another year, lawyers in the case say.